Lecture Economics (18th edition): Chapter 27 - McConnell, Brue, Flynn''s

Chapter 27
Basic
Macroeconomic
Relationships
McGraw­Hill/Irwin

        Copyright © 2009 by The McGraw­Hill Companies, Inc. All rights reserved.


Chapter Objectives
• Effect of changes in income on
consumption (and saving)
• Other factors that affect consumption
• Effect of changes in real interest rates
on investment
• Other factors that affect investment
• Changes in investment have a
multiplier effect on real GDP
27-2


Basic Relationships
• Income and consumption
• Income and saving
• Disposable income (DI)
• 45°line for reference
–C = DI on the Line

• S = DI - C
27-3

Income and Consumption
Consumption (billions of dollars)

10000
9000

05

45° Reference Line
C=DI

8000

04
03

7000

00

02
01

C

99

6000

Saving
In 1992

5000
4000
3000

83

2000

84

97

91
90
89
88
87
86
85

98

96
95
94
93
92

Consumption
In 1992

1000
45°

0
0

2000

4000

6000

8000

10000

Disposable Income (billions of dollars)
Source: Bureau of Economic Analysis

27-4


Consumption and Saving
•
•
•

•

The consumption schedule
The saving schedule
Break-even income
Average propensity to consume
(APC)
• Average propensity to save (APS)
Consumption
APC =
Income

APS =

Saving
Income
27-5


Consumption and Saving
• Marginal propensity to
consume (MPC)
• Marginal propensity to save
(MPS)
Change in Consumption
MPC =
Change in Income
Change in Saving
MPS = Change in Income
27-6

Consumption and Saving
(1)
(4)
(5)
(6)
(7)
Level of
Average
Average
Marginal
Marginal
(2)
Output
Propensity Propensity Propensity Propensity
Consump(3)
And
to Consume to Save
to Consume to Save
tion
Saving (S)
Income
(APC)
(APS)
(MPC)
(MPS)
(C)
(1) – (2)
(GDP=DI)

(2)/(1)
(3)/(1)
Δ(2)/Δ(1)
Δ(3)/Δ(1)

(1) $370

$375

$-5

1.01

-.01

(2)

390

390

0

1.00

.00

(3)

410

405

5

.99

.01

(4)

430

420

10

.98

.02

(5)

450

435

15

.97

.03

(6)

470

450

20

.96

.04

(7)

490

465

25

.95

.05

(8)

510

480

30

.94

.06

(9)

530

495

35

.93

.07

(10) 550

510

40

.93

.07

MPC + MPS = 1

.75

.25

.75

.25

.75

.25

.75

.25

.75

.25

.75

.25

.75

.25

.75

.25

.75

.25

MPC and MPS measure slopes
27-7


Consumption (billions of dollars)

Consumption and Saving
500

C

475
450
425

Saving $5 Billion

400

Consumption
Schedule

375

Dissaving $5 Billion

Saving
(billions of dollars)

45°
370 390 410 430 450 470 490 510 530 550

Disposable Income (billions of dollars)
50 Dissaving
Saving Schedule
S
$5
Billion
25
Saving $5 Billion
0

370 390 410 430 450 470 490 510 530 550

27-8


Average Propensity to Consume
Selected Nations, with respect to GDP, 2006
.80

.85

.90

.95

1.00

United States
Canada
United Kingdom
Japan
Germany
Netherlands
Italy
France
Source: Statistical Abstract of the United States, 2006

27-9


Consumption and Saving
• Nonincome determinants of
consumption and saving
– Wealth
– Borrowing
– Expectations
– Real interest rates

27-10

Consumption and Saving
• Other important considerations
– Changes along schedules
– Switch to real GDP
– Schedule shifts
– Stability
– Taxation
27-11


Consumption and Saving
Consumption (billions of dollars)

C1
C0
C2

Saving
(billions of dollars)

45°

Disposable Income (billions of dollars)
S2
S0
S1

27-12

Interest Rate and Investment
• Expected rate of return (r)
• The real interest rate (i)
– Nominal rate less rate of inflation

• Meaning of r = i
• Investment demand curve

27-13


Investment Demand Curve

16%
14%
12%
10%
8%
6%
4%
2%
0%

$ 0
5
10
15
20

25
30
35
40

16
14

r and i (percent)

Expected
Rate of
Return (r)

Cumulative
Amount of
Investment
Having This
Rate of
Return or Higher
(I)

12
10
8
6
4
2
0

ID
5

10

15

20

25

30

35

40

Investment (billions of dollars)

27-14


Investment Demand Curve
• Shifts of the curve
– Acquisition, maintenance, and
operating costs
– Business taxes
– Technological change
– Stock of capital goods on hand
– Planned inventory changes

– Expectations

27-15


Investment Demand Curve

r and i (percent)

Increase in
Investment Demand

Decrease in
Investment Demand

ID2 ID0

ID1

0

Investment (billions of dollars)
27-16


Investment Demand
• Instability of investment
– Durability
– Irregularity of innovation
– Variability of profits

– Variability of expectations

27-17


Gross Investment Expenditure
Percent of GDP, Selected Nations, 2006
0

10

20

30

South Korea
Japan
Canada
Mexico
France
United States
Sweden
Germany
United Kingdom
Source: International Monetary Fund

27-18


Volatility of Investment

Source: Bureau of Economic Analysis

27-19


The Multiplier Effect
• More spending results in higher
GDP
• Initial change in spending changes
GDP by a multiple amount
Multiplier =

Change in Real GDP
Initial Change in Spending

27-20


The Multiplier Effect
• Causes of the initial change in
spending
– Changes in investment
– Other changes

• Rationale
– Dollars spent are received as
income
– Income received is spent (MPC)
– Initial changes in spending cause

a spending chain

27-21


The Multiplier Effect
Increase in Investment of $5
Second Round
Third Round
Fourth Round
Fifth Round
All other rounds

Total

(2)
(3)
Change in
Change in
(1)
Saving
Change in Consumption
(MPC = .75) (MPC = .25)
Income
$ 5.00
$ 3.75
$ 1.25
3.75
2.81
.94

2.81
2.11
.70
2.11
1.58
.53
1.58
1.19
.39
4.75
3.56
1.19

$ 20.00

$ 15.00

$ 5.00

$20.00

$4.75

15.25
13.67
11.56
8.75
5.00

$1.58

$2.11
$2.81
ΔI=
$5 billion

$3.75

$5.00
1

2

3
4
Rounds of Spending

5

All
27-22


The Multiplier Effect
Multiplier =

1
1 - MPC

-orMultiplier =

1
MPS
27-23


The Multiplier and the MPC
MPC

Multiplier

.9

10

.8

5

.75

4

.67
.5

3
2
27-24

Squaring the Economic Circle
• Humorist Art Buchwald and the
multiplier
• Suppose one person can’t buy a
product
• Others subsequently impacted and
cannot buy other items
• Multiple effects impact psyche
• Ultimately causes multiple step impact
upon the economy as a whole
27-25